Boon or tsunami? Non-lawyer investment in law firms

February 1st, 2012
x
Bookmark

By Shadrack Maile

Several countries are allowing or are moving to allow private investment in and ownership of law firms. The focus of this article is on the role of limited participation in law firms by non-lawyers for investment purposes, that is, ownership by non-lawyers who are not providing professional services within the law firm. There are split opinions on the potential for this type of investment.

One school of thought represents the ‘fear of Sears’. This fear is based on the vision of large retail institutions, such as Sears, buying up law firms to create a large mega firm and, in the process, putting many smaller firms out of business.

Another school of thought views this kind of investment as representing a tsunami of change that is long overdue market liberation and a boon to consumers.

Global trends

Interest in non-lawyer investment in law firms was generated by, among others, the success of the big accounting firms in other parts of the world. Below is a summary of some of the developments around the world that are fuelling this debate.

United States of America (USA)

Forty-nine of the 50 states in the USA prohibit non-attorney investment in law firms. Model Rule 5.4 of the American Bar Association’s Model Rules of Professional Conduct constitutes the professional code in all the states. Model Rule 5.4(b) provides that a lawyer shall not form a partnership with a non-lawyer if any of the activities of the partnership constitutes the practice of law. Model Rule 5.4(d)(1) provides that a lawyer shall not practise with, or in the form of, a professional corporation or association authorised to practise law for a profit if a non-lawyer owns any interest therein.

One exception is Washington DC, where outside investment in law firms is allowed under certain conditions.

Washington DC r 5.4(b) allows for an equity interest by a non-lawyer whose sole function is managerial and provides that a lawyer may practise law in a partnership in which a financial interest is held, provided:

  • The partnership has as its sole purpose the provision of legal services to clients.
  • All persons holding a financial interest undertake to abide by the Rules of Professional Conduct.
  • The lawyers who have a financial interest or managerial authority in the partnership undertake to be responsible for the non-lawyer participants to the same extent as if non-lawyer participants were lawyers under r 5.1.
  • The foregoing conditions are set forth in writing.

In North Carolina there is proposed legislation that would allow outside investment in law firms (Senate Bill 254). In terms of this, non-attorneys would be permitted ownership interests in law firms not exceeding 49%. The proposal also provides that a non-lawyer shareholder shall not interfere with the exercise of professional judgment by attorneys in representing clients.

Recently, USA law firm Jacoby & Myers instituted an action to overturn the existing ban on outside ownership, arguing that it perpetuates economic inequity because smaller firms do not have the same access to capital markets for expansion as larger firms. To attain the reach it seeks, it needs equity partners and cannot rely solely on partners’ equity and bank loans. In the lawsuit, the firm argues that, because of the fee-sharing ban, critical sources of funding are not available to a majority of lawyers, which dramatically impedes access to legal services for those otherwise unable to afford them.

United Kingdom (UK)

Recently the UK has allowed lawyers to partner with non-lawyers. The change in British law, introduced by the Legal Services Act 2007 (c29), enables law firms to use external investments and initial public offerings.

The British law allows a new business model that must be at least 51% owned and controlled by attorneys. In an attempt to avoid improper influence by non-lawyers, the Legal Services Act sets out specific measures to curb this, including:

  • Any firm with non-lawyers partners, directors or shareholders must be licenced as an alternative business structure (ABS).
  • All non-lawyers involved in an ABS have a statutory duty not to contribute to a breach of legal professional duties by the firm or anyone in it.
  • ABS regulators can ban defaulting non-lawyers from any future involvement in ABS firms and can fine and revoke the licences of an ABS.
  • Any shareholder, including a partner or director, wishing to own 10% or more of an ABS must be certified as fit and proper by the regulatory body. The potential shareholder bears the burden of proof.
  • The ABS regulators can attach conditions to investors, or even divest them of their shares, if they fail to meet the prescribed standard.

Australia

Non-lawyers do invest in law firms in Australia and law firms are permitted to be publicly traded. Law firm Slater & Gordon, for example, has been publicly traded since 2007.

South African position

The attorneys’ profession is presently governed by the Attorneys Act 53 of 1979.

Section 23(1)(b) of the Act provides that a private company may, notwithstanding anything to the contrary contained in the Act, conduct a practice if only natural persons who are practitioners are members or shareholders of the company or persons having any interest in the shares of the company. Section 23(2) further provides that only a shareholder of the company shall be a director thereof.

Section 83(6) of the Act provides that a practitioner shall not make over to or share or divide with any person, other than a legal practitioner, commission or allowance or any portion of his professional fees.

The Attorneys Act may soon be replaced by the Legal Practice Act, which is currently in the form of a Bill. Section 36 of the December 2010 draft Bill contains provisions similar to s 83(6).

The case against non-lawyer investment

One argument against non-lawyer investment emanates from potential investors who are concerned that lawyers are not proven business leaders. They point out that few managing partners know their firm’s profit per billable hour, even though this is the main product law firms sell. Cost control is often seen as an afterthought, trailing far behind revenue generation (‘Should you buy shares in a law firm?’ 21-8-2008 The Economist).

It is argued that lawyers have never had to endure the same pressures as managers of listed companies, where the shareholders call the shots. In law firms equity is held by a small number of partners. Outside investors are sure to be less sentimental and more critical when analysing a firm’s performance (The Economist (op cit)).

In addition, some corporate clients may not want to take the risk that their company’s confidential business could wind up exposed in some shareholder lawsuit against the firm.

Those who are opposed to non-lawyer investment in law firms argue that lawyers owe a duty to their clients and not to shareholders, and non-lawyers would not understand a lawyer’s obligations.

It is argued that lawyers who are in favour of outside investment do not need capital but rather wish to ‘sell and walk away’. It is contended that many of those in big law firms who already take a short-term economic view of firms would leap at the opportunity for a one-time pay day.

It is pointed out that law firms are low-capital businesses, able to self-fund operations without the need for deep-pocketed backers. The point made being that, besides an office and standard business upkeep, there is very little physical equipment a law firm needs to operate. Nearly all of its capital is human capital, locked in the brains of its lawyers (M Housel ‘A new way to be bamboozled by your lawyer’ The Motley Fool 23-5-2011).

Those who oppose non-lawyer investment argue that their introduction into ownership structures would increase pressure to earn profits and would inevitably result in interference with a lawyer’s professional independent judgment. The fear is that non-lawyer owners would act as a compromising influence, interfering with the behaviour of lawyers so that their organisations would focus more on the organisation’s business and less on the best interests of the client.

The investment by non-lawyers is seen as having the potential to impede the legal profession’s duty to make the legal system accessible to the public in two primary ways. Firstly, with the use of non-attorney capital, law firms will incur a set of duties to new constituencies, that is, duties to investors and to the investment market. These duties may not seriously affect the firm/client relationship, but could impact on the firm’s performance of duties to society. For example, if the non-attorney investors are only interested in profits and they have control of the firm, pro bono work would ultimately be sacrificed. Secondly, non-attorney investment could lead to a more regulated legal profession and thereby, it is argued, impede the profession’s effectiveness as an advocate for the people against the government. Attorneys enjoy an extremely high level of autonomy. Both the courts and the law societies control the regulation of attorneys in a manner free from government interference. (See B Sharfman ‘Modifying Model Rule 5.4 to allow for minority ownership of law firms by nonlawyers’ (2000) 13.3 The Georgetown Journal of Legal Ethics.)

The argument is that the greater the investment by non-attorneys in law firms, the more law firms will look like other businesses and less reason will exist not to regulate them like any other business. If non-attorney involvement were to lead to government regulation of the legal profession, the obligation of lawyers to challenge the government in the interest of citizens would be diminished as attorneys would face their own regulator as their adversary (Sharfman (op cit)).

Some opponents of non-lawyer investment believe it would incentivise law firms to engage in ethical lapses. For example, it is pointed out that investors will not understand the need for confidentiality. The fear is that attorneys in such partnerships would escape the rules by having non-lawyers conduct unethical activities. A lawyer who breaks ethical rules would be subject to discipline, while a non-lawyer has nothing at stake, so the argument proceeds.

The case in favour of non-lawyer investment

On the other hand, others argue that law firms operate in a short-sighted manner in order to boost short-term returns without spending sufficient sums on knowledge management, process improvement and document automation to drive increased value for clients. Consideration should be given to a more long-term economic strategy driven by outside investment which might substantially improve the quality of a law firm for its clients (‘Different types of law firms’, www.whichdraft.com, 12-7-2011).

The proponents of non-lawyer investment argue further that a prohibition unconstitutionally restricts commerce by limiting attorneys’ ability to act like other businesses. The legal industry is seen as cloaking ‘anti-competitive injunctions with the cloth of “ethics”’ (see B MacEwan, MS Regan Jr & L Ribstein ‘Law firms, ethics, and equity capital: A conversation’ (2007) 21.61 The Georgetown Journal of Legal Ethics 87). Besides, the argument goes further, legal business is now international and international competition could break down the resistance of tradition and history. Firms have grown substantially and some have opened multiple offices. Most large law firms employ a cadre of non-lawyer professionals in executive and managerial positions and vigorously market their services. Most firms are also incorporated. In these and other respects, law firms have come to closely resemble their corporate clients (MacEwan, Regan & Ribstein (op cit) at 62).

The argument stresses that, given the complex variety of modern legal services, it is impractical to define organisational firms that uniquely can guarantee compliance with the rules of professional conduct (‘Final Draft Model Rules of Professional Conduct’ (Nov 1982) 68 American Bar Association Journal). The objection that the very existence of shareholders creates pressure that will lead firms to focus blindly on maximising profits is criticised as being misplaced. Permitting outside equity ownership is not likely to change the pressures felt by law firms. Analysts point out that the only difference likely to occur is emphasis on the share price. It is pointed out that maximising profits per partner is at least as compelling to a firm as any imperative to maximise share price. Any lawyer who generates enough revenue to be a senior equity partner probably also generates enough to be an attractive candidate in the lateral market. For some of these partners, the portability of their practice can result in minimal commitment to a firm. Such partners are the equivalent of short-term shareholders who would not hesitate to seek a better return elsewhere (M Regan Jr ‘Nonlawyer ownership of law firms might not cause the sky to fall’, www.americanlawyer.com, 14-8-2007).

It is argued that abolishing the prohibition on non-lawyer investment would level the playing field because small firms do not have the same access to capital that listed companies have. Their ability to improve technology, infrastructure, expand offices and hire personnel is restricted. Law firms subjected to this prohibition are at a competitive disadvantage if counterparts can obtain funding from non-lawyer investors in other parts of the world. In general, an influx of capital brings growth and stability into business and private equity capital tends to bring discipline and promote the market forces brought by capitalism.

In a start-up situation equity financing is preferable to conventional bank financing because the periodic debt payments are a cash drain on the partnership while there is no obligation for periodic payments with equity financing (ES Adams and JH Matheson ‘Law firms on the big board?: A proposal for nonlawyer investment in law firms’ (Jan 1998) 86.1 California Law Review).

Access to non-lawyer equity capital will make it easier and less financially risky for law firms to enter new markets and will help increase consumer choice. By using non-lawyer capital, a firm could expand into a new market without risking as much of its own partner capital or bank borrowing.

Law firms regularly approach banks for loans and, when they do, banks often have regulations about certain aspects of the practice. Why should it be different if there is equity rather than debt, so long as attorneys’ duties to clients are protected and regulated?

There is a sound economic argument for the maintenance of an attorney’s professional independent judgment regardless of having non-lawyer owners. Non-attorney owned law firms would still be in the business of providing legal services and could only succeed if they continued to provide sound legal judgment to their clients. The value of the firm would be directly related to the investor market’s perception of the ability of the firm to deliver quality legal services to clients. To the extent that the firm’s reputation is tarnished by providing advice based on non-independent judgment, the non-lawyer investors stand to lose. There would thus be considerable incentives for firms with non-lawyer investors to maintain a high level of client service (Sharfman (op cit)).

Law firms make a significant investment in each attorney they hire in the form of training and providing an institutional understanding of how the firm operates. This investment occurs over a period of years. Historically, clients had shouldered most of these training costs through the billing system. The alternative has been to internalise training costs as overhead costs, requiring them to be financed with partner capital. Non-attorney capital could be used to help finance these training costs, thereby reducing a drain on partner capital (Sharfman (op cit)).

Law firms that take cases on a contingency fee basis must fund significant upfront expenditure with partner capital. By using non-lawyer capital, law firms that are relatively less risk averse can take on more contingency fee cases where they believe the client’s claim or cause is meritorious but where the outcome may be in doubt. Once such a case is undertaken, maintaining adequate litigation is another concern that needs to be addressed. Where the plaintiff’s firm is suffering financially, this may affect the outcome of settlement negotiations. Having non-lawyer equity capital available may ease the pressure of lengthy litigation and enhance the ability of plaintiffs’ attorneys to provide clients with effective representation (Sharfman (op cit)).

Over-dependence on bank borrowing and the associated requirement of making periodic interest payments may place a severe financial strain on a law firm and its lawyers, putting pressure on their independence of judgment about what is best for the client. The availability of non-lawyer equity would allow law firms to reduce the risk to their capital structure and the threat of bankruptcy by substituting equity for bank borrowings. Through the use of non-lawyer investment, a capital structure more heavily weighted toward equity can be created, thereby reducing the financial pressure on the firm and reducing whatever pressure it creates on the professional independent judgment of the firm’s attorneys (Sharfman (op cit)).

While some lawyers can earn handsome income as senior partners, lawyers do not have material wealth-creation opportunities. They do not have stock options nor supernormal income windfalls to be invested long-term for meaningful wealth creation. This state of affairs leaves law firms at a competitive disadvantage when it comes to recruiting and retaining talent. Partners of law firms have seen their firms’ gross annual revenues double or more during their tenures, with no way of personally benefiting from what would be the handsome performance of the law firm’s ‘stock’ in a way that any corporate chief executive officer would as a matter of routine. In addition, these partners also have to keep substantial amounts of personal capital locked up inside the firm, earning zero interest.

Conclusion and recommendation

I propose that the appropriate solution is not prohibition but regulation. I further propose that the extent of non-lawyer ownership should be limited to 49%, thus leaving attorneys as majority shareholders.

Beyond controlling the number of shares issued to outsiders, a law firm could adopt the proposal by Sir David Clementi, who was asked to study the feasibility of firms going public in Britain, to prohibit investors from involvement in any matter the firm is handling and from having access to any client information. Investors in the firm would be explicitly advised that their share interests would contain these limitations (D Clementi ‘Review of the regulatory framework for legal services in England and Wales’ (2004), www.jambar.org, accessed 18-1-2012).

It is proposed that Washington DC r 5.4(b)(3), which provides that lawyer partners are to be responsible for the actions of their non-lawyer partners, be adopted.

Furthermore, the financial control of law firms must be kept in the hands of attorneys. A critical feature of the minority ownership proposal is that lawyers would retain control of their firm, which they can do by contractual means, thereby minimising the influence of non-lawyer owners. The contract should provide that the attorneys retain all management authority, responsibility and accountability and that the minority non-lawyer investor should not take an active role in the management of the firm. The advantage of minority ownership by non-lawyers is that it gives the majority attorney partners voting control.

Shadrack Maile BIur (University of Zululand) LLB (UKZN) LLM BBA (Unisa) Cert in compliance management (UCT) is the board secretary at the Attorneys Fidelity Fund in Cape Town. He writes in his personal capacity.

This article was first published in De Rebus in 2012 (Jan/Feb) DR 20.

X